Reduce Investment Risk With Dollar Cost Averaging

by Scott Sery on August 22, 2012

As we have all seen over the past several years the stock market can be very turbulent.  Everything seems to be going fine, then after a bit of bad news from the media and it is thrown into turmoil again.  For those who are looking to invest, this can be off putting.  They want to get the best deal on their investments, this means to buy low.  But without knowing where the true low is, how does one not make the mistake of buying high?  By taking a systematic approach, called dollar cost averaging, one can help to balance out roller coaster affect that the market has.

The market always has, and always will go up and down.  Often it happens for seemingly no reason at all.  For those who have come into a large sum of money, they do not want to make the mistake of investing it all at once, and getting in at a market peak.  The investment risk (that is the risk of losing money on an investment) associated can be troublesome.  Instead, putting in a little bit over a period of time a person can dollar cost average their way into the market.

Example of Dollar Cost Averaging

John inherits $120,000 from his grandparents.  It is paid to him in a lump sum.  He wants to invest the money into a balanced mutual fund, but does not want to put it all in only to have it immediately lose value.  Instead he will put it into the money market, and once per month, for the next year, he will have $10,000 transferred into the fund of his choosing.  This way if he is at a market peak this month, he will only put 1/12 of his money in at the high.  Consider the following values per share of the fund John uses:

January 1:                    $8.50
February 1:                   $9.00
March 1:                       $11.00
April 1:                          $10.00
May 1:                            $9.00
June 1:                           $8.00
July 1:                            $7.50
August 1:                      $7.00
September 1:                $8.00
October 1:                     $7.50
November 1:                 $6.50
December 1:                 $7.00

If John were to put all $120,000 in on January 1st, he would buy 14,117 shares.  By December those shares would be worth $98,823 (not including any dividends he may have received).  On the other hand, if he had put in $10,000 per month, he would have bought some shares at a higher price, and some shares at a lower price.  By the time December came, John would have 14,867 shares that were worth $104,076.  By spreading out the time period in which he invested John was able to gain 750 shares and make his investment worth over $5,000 more than if he dumped all the money in at once.

Investing is important, and it is important to know that most investments are going to last much longer than one year.  When sudden windfalls occur, the best thing a person can do is to slowly start putting that money into the market.  That way they can minimize their exposure to overpriced funds, and maximize their exposure when those funds are underpriced.  Doing so will result in a portfolio that not only has less volatility, but also shows greater gains.

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Scott Sery

Scott Sery is a native to Billings, Montana. Within an hour in nearly any direction he can be found fishing, hunting, backpacking, caving, and rock or ice climbing. With an extensive knowledge of the finance and insurance world, Scott loves to write personal finance articles. When not talking money, he enjoys passing on his knowledge of the back country, or how to live sustainably. You can learn more about Scott on his website Sery Content Development
  • Veronica @ Pelican on Money

    Awesome tip, and makes a lot of sense. Any others? 🙂 keep em coming.

  • John S

    Nice post. Dollar cost averaging can definitely be a useful tool when investing in the market. It can also help take the emotion out of the investing by having a plan to follow.

  • Good outline of this time-tested technique. I’ll add that this works well with no-load funds because there’ll be no cost to spread your investment out over time instead of doing it all at once.

  • Jason @ WorkSaveLive

    Dollar cost averaging is a HUGE deal. In that scenario you just gave that was a 5% difference in return…that may not sound like a lot to some people but it makes an extremely significant difference over 20-40 years.

    Many people dollar cost average and just don’t realize it. Contributing monthly or bi-weekly to your 401k is one way of doing it. All of my Roth or IRA clients also get encouraged to contribute monthly or bi-weekly.

  • Dollar cost averaging is the way to go for the average investor. It helps to take emotion out of investing. That emotion is what causes the average investor to see annual returns of 2% when they could be getting higher returns otherwise.

    And, it’s simple to set up if you use Vanguard or another mutual fund firm. Just pick the day and have them debit your checking account and boom, you are done and on the road to nice returns.

  • Nice example! I did a post a while back where I DCA across The Lost Decade. It turns out you would have still lost money, but not as badly – which is still a win!

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